Investment banks? What investment banks, says the alert reader. They are all gone, either bought by big banks, dead, or forced to become them so as to be able to pull funds from the Federal Reserve more readily.

The Financial Times report that the changes to the bankruptcy law in 2005 may have played a role in the undoing of these firms. The danger for an investment bank, as the Bear Stearns case illustrated, is that counterparties can become nervous about having credit exposure and can start curtailing certain types of activities and close accounts that would be frozen in bankruptcy. Worse, if a firm is downgraded beyond a certain point, counterparties will stop trading with the troubled firm because exposure to that firm would get them downgraded. And an inability to trade is a death knell for a securities firm.

The irony is that carveouts in the 2005 bankruptcy reform bill intended to help investment banks appear to have worked in the opposite fashion. From the Financial Times:

Wall Street unwittingly created one of the catalysts for the collapse of Bear Stearns, Lehman Brothers and American International Group by backing new bankruptcy rules that were aimed at insulating banks from the failure of a big client, lawyers and bankers say.

The 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company’s assets until a court decides how to apportion them among creditors.

The new rules were intended to insulate financial companies from the collapse of a large counterparty, such as a hedge fund, by making it easier for them to unwind trades and retrieve collateral.

However, experts say the new rules might have accelerated the demise of Bear, Lehman and AIG by removing legal obstacles for banks and hedge funds that wanted to close positions and demand extra collateral from the three companies.

“The changes were introduced to promote the orderly unwinding of transactions but they ended up speeding up the bankruptcy process,” said William Goldman, a partner at DLA Piper, the law firm. “They wanted to protect the likes of Lehman and Bear Stearns from the domino effect that would have ensued had a counterparty gone under. They never thought the ones to go under would have been Lehman and Bear.”…

The changes in the code expanded the scope and definition of financial transactions not covered by bankruptcy rules to include credit default swaps and mortgage repurchase agreements – products used widely by Lehman, Bear and AIG.

Lawyers said under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.

However, when the financial health of Bear, Lehman and AIG took a sharp turn for the worse this year, their trading counterparties – mainly hedge funds and other banks – were not deterred from seeking to settle their trades or forcing the three companies to put up more collateral.

Such pressure exacerbated the liquidity squeeze that ultimately forced the three companies to hoist the white flag. Bear was sold to JPMorgan in a cut-price deal in March, while Lehman filed for bankruptcy last month and AIG was rescued by a $120bn government loan.

Lawyers said the 2005 exemptions also could apply to non-financial companies, potentially complicating the bankruptcy process of any company that uses derivatives. Stephen Lubben, professor at Seton Hall University School of Law, said: “These provisions affect a non-financial firm, such as a car company or an airline, because they also engage in derivatives trading.”

I am mystified why you are posting this article as “news”…what are the news here? That you have to post collateral to play? And that the law had to be perfected in this regard? Yes, if you make the wrong calls, you have to post more collateral – this is what every prudent creditor would ask for!!!

Remember when Merril Lynch Pierce Fenner and Bean and other HONORABLE investment banks were partnerships with the partners putting their own money at risk? In my jaundiced view this whole financial problem is caused by government intervention in the markets. Business cycles are normal. GET OVER IT.

. . . public tranquility is a great good, but . . . all nations have been enslaved by being kept in good order. de Touqueville

“Dearth of Credit” by Ludwig von Mises: “An increase in the quantity of money or fiduciary media is an indispensable condition of the emergence of a boom. The recurrence of boom periods, followed by periods of depression, is the unavoidable outcome of repeated attempts to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved. The breakdown appears as soon as the banks become frightened by the accelerated pace of the boom and begin to abstain from further credit expansion. The change in the banks’ conduct does not create the crisis. It merely makes visible the havoc spread by the faults which business has committed in the boom period. The dearth of credit which marks the crisis is caused not by contraction but by the abstention from further credit expansion. It hurts all enterprises – not only those which are doomed at any rate, but no less those whose business is sound and could flourish if appropriate credit were available. As the outstanding debts are not paid back, the banks lack the means to grant credits even to the most solid firms. The crisis becomes general and forces all branches of business and all firms to restrict their activities. But there is no means of avoiding these consequences of the preceding boom. Prices of the factors of production – both material and human – have reached an excessive height in the boom period. They must come down before business can become profitable again. The recovery and return to “normalcy” can only begin when prices and wage rates are so low that a sufficient number of people assume that they will not drop still more.”

‘Now the women are taking over,’ a spectacularly non-PC government official told the FT. ‘It’s typical, the men make the mess and the women come in to clean it up.’ And the political will is clearly there for the pair to make sweeping changes to the way the banks operate. The paper suggests that Icelanders casting around for someone to blame for their current predicament have settled on young bonus-hungry male bankers, whose ‘eyes became bigger than their stomachs.’

A question for the gentle readers. Even though AIG was ‘bailed out’ by the govt., is there anything to keep it from still going under, aside from the insane govt. desire to preserve the good works already done?

As North Carolina was shipping jobs offshore, both Republican Senators, Richard Burr and Elizabeth Dole, voted in favor of the 2005 law. The lobbying arm is the American Bankers Association. Elizabeth Duke, former president, is now a Fed governor. Dole is fighting for re-election.

Alan Greenspan and dimwit US Labor Secretary Elaine Chao have chirped health sciences: registered nurse, anesthetist, xray technician. Business Week magazine, 2006 ran an article about how bad the job “specialization” (Greenspan’s term) will be for the US GDP.

Am I missing something here? Didn’t this change effectively subordinate the senior debt of any corporation using derivatives? Has anyone told the holders of this debt? And given the possible volatility of derivatives holdings, how can a senior debt holder ever know the value of his investment?